How traders can take advantage of volatile markets
To make money in financial markets, there must be price movement. Fortunately, price movement is a constant in the markets. The key factor is how fast prices move. The speed or degree of change in prices is called volatility, which produces volatile markets. The good news is that as volatility increases, so does the potential to make more money quickly. The bad news is that higher volatility also means higher risk. When volatility spikes, you have the opportunity to generate an above-average profit, but you also risk losing a lot of capital in a relatively short time. With a disciplined approach, you can learn to manage volatility to your advantage – while minimizing risk. Here are four steps to consider to take advantage of volatile markets.
1. Define your goals and strengthen your defenses
Before embarking on a course to trade volatile markets, it’s important to be mentally and tactically prepared to manage the risks. So the first step is to make sure that: – You are comfortable trading when volatility is high. – You realize that there is potential for significant capital loss and are prepared for this risk. Assuming you are ‘ready for action’, the next wise thing to do is to review the risk control measures you have as part of your trading plan. Two important considerations are position size and stop-loss placement. During volatile markets – when daily price swings are typically larger than normal – some traders make smaller trades (tying up less capital per trade) and use a wider stop-loss than they would when markets are quiet. The goal is to avoid getting stopped out due to larger than normal price fluctuations during the day while trying to keep your overall risk exposure about the same. As always, traders should note that stop orders may be executed far away from the stop price if there is a large price gap or rapidly changing market conditions.
2. Focus on stocks that trend with the market
An important opportunity when trading volatile markets is that trending stocks can actually see the pace of their trend increase. This means that looking for stocks that are already trending in the direction of the overall market can give a trader the opportunity to generate profits faster than during normal, quieter markets, albeit at a potentially higher risk, as previously mentioned. The key to this approach is to find a stock that has been trending higher (if the stock market is in an uptrend) but has not yet accelerated the pace of its advance. A short seller trading in a volatile market should look for a stock that has fallen but has not already experienced a collapse or “waterfall” decline. The goal is to get in before an acceleration in price, not after.
3. Watch out for outbreaks from consolidations
A common trading method used by many traders is to ‘buy the breakout’. With this approach, a trader monitors a stock trading within an identifiable support and resistance range. As long as the stock is within that range, no action is taken. But if the price goes up, the trader will try to buy the stock immediately, hoping that the breakout signals the beginning of a new rise for the stock. In quieter markets, a stock may go up and lose momentum, slide sideways, or eventually fall back below the breakout level. But in a volatile market, where prices move quickly, an upward breakout can be followed by an immediate and substantial rise to higher prices. This kind of potential is the main reason to trade breakouts in a volatile market environment. The catch is that in a volatile market, a reversal from a false breakout can come very quickly and the subsequent price decline can be more severe than in a quieter market. As a result, a trader who chooses to buy the breakout in a volatile market should seriously consider a stop-loss order to potentially limit his loss after the price falls a certain distance back below the breakout point (or some other acceptable percentage).
4. Consider short-term strategies
Another approach traders use when markets are volatile is to adopt a short-term trading strategy. This usually involves trying to take profits – or at least lock in profits – faster than normal. Consider the example of a trader who typically buys stocks when they break out above resistance. Normally, after entering a trade, this trader places a stop-loss X% below the entry price and then waits for a profit of at least Y% to accumulate before activating a trailing stop – that is, a conditional order that uses a trailing amount, rather than a specific stated stop price, to determine when to send a market order. The trailing amount, specified in either points or percentages, then follows (or ‘tracks’) a stock’s price as it moves up (for sell orders) or down (for buy orders). As the stock rises in price, the trailing stop will also rise, allowing you to potentially sell at a higher price. However, in more volatile markets, when profits can disappear and turn into losses in an instant, you may consider making the following adjustments to close the trade faster: – Set a specific percentage profit target; – Sell part of a position at the first good profit-taking opportunity and keep the remaining position in the hope of generating further profits. – Use an overbought/oversold type indicator (RSI for example) and sell when it signals that the security is overbought. – Activate a trailing stop loss earlier than normal and/or use a tighter stop than normal.
Be prepared
Traders crave price movements because it gives them an opportunity to make bigger profits. But sometimes price movements can accelerate beyond what they are used to. A driver traveling at 100 miles per hour has the potential to reach his destination faster than one traveling at 60 miles per hour. However, the first driver must be prepared to deal with all the dangers that come with driving at such a high speed. The same goes for traders. When market volatility reaches a certain level, things can start to move so quickly that closer attention and a change of tactics may become necessary. The key is to prepare in advance. The steps discussed in this article are no guarantee to keep you on course, but are worth considering if you think you are ready to take on volatile markets.
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